Last Updated Oct 12, 2010 6:23 PM EDT
Dan Ariely, Duke behavioral economics professor and bestselling author, kicked off the annual Financial Planning Association (FPA) Conference this week in Denver, Colorado. This gathering of thousands of financial planners from across the globe promised to leave planners "feeling confident that (we) were exposed to new ways of thinking," and "challenged to view standard practices in a new light."
In his speech, Ariely challenged planners to help clients think about money, and to try new things with their clients. He stated that planners' main contribution to clients isn't in building the portfolio, but rather in understanding how to use their money in a way that would maximize their happiness. And to do this, he said, we need to understand the psychology of money. During my interview with Ariely, he noted that one of the main problems with thinking about money is that people often don't take into account opportunity cost, and what they would have to give up in the future.
To illustrate this point, he talked about the decision to buy a new car. Buyers are excited about the enjoyment it will bring, but don't consider what sacrifices must be made when making such decisions, such as fewer nights dining out, or delaying retirement.
Ariely discussed the ways that planners can use behavioral finance, either for good or evil. He gave the example of meeting with a client and selecting the overall risk in the portfolio asset allocation, and noted that the planner could kick off this client session by using either opening:
- Think of the days during the past three years during the stock market plunge where your portfolio lost more than five percent. How did you feel?
- Imagine your ideal retirement. Where would you live and what would you be doing?
I'm extrapolating his work here, but I can imagine the first question leading to the sale of an insurance annuity with guarantees, and the second question leading to selling a ProShares triple levered inverse index fund.
Pain of Paying
Ariely spoke to planners about the pain of paying. One way to make a cruise more enjoyable is to pay up front. If you pay for it at the end of the cruise you might spend the last few days wondering if you had made the right decisions. That may also explain why last summer, on the final day of our cruise, I amortized my investment at the ship's buffet. This is also why all inclusive resorts, even if they are more expensive, can make sense - because we don't experience the pain of paying to the same degree.
In our meeting, Ariely noted that most people pay for their portfolio management in a manner that isn't painful. In fact, the percentage of assets method is automatically taken out in a way that's easy to ignore or even miss. Without customers feeling the pain of paying, planners don't get the feedback and don't change our behavior.
Ariely's message to planners
Dan's message to planners had three points:
- We have lots of irrational tendencies.
- We are not aware that we have them.
- We need to start experimenting and trying different things for our clients.
Indeed, awareness of our irrational behavior is the first step to improving our economic choices. This is true whether it's investing or making every day decisions. The best we can do is to be aware of what emotional factors are driving us. Though we can't eliminate all of our irrational behavior, we can fight some of them. That's a dog we're always going to have to keep on a leash.
When we're talking about dollars and cents, you can be sure it's the common sense that often flies out the window. Accept the fact that money is emotional, and think about how you may be acting irrationally. And, most importantly, think about how the financial services industry is framing things to lead you to make a decision that may not ultimately be in your best interest.